Recent guidance by the Internal Revenue Service gives new insight into the agency’s plan to enforce required minimum distributions (RMDs) on certain beneficiaries of inherited retirement plans and IRAs.

The passage of the SECURE Act in 2019 created new rules for beneficiaries who inherited an IRA or defined contribution retirement plan after December 31, 2019. Before the SECURE Act, beneficiaries could spread their withdrawals or required minimum distributions (RMDs) over their lifetime—potentially allowing the remaining balance to grow tax-deferred over a longer time horizon.

Now, some beneficiaries must withdraw the balance of their inherited retirement assets within ten years of the original owner’s death, accelerating the income tax due, and potentially impacting strategies to transfer wealth to future generations.

Under the law, two main classes of beneficiaries exist—eligible designated beneficiaries and non-eligible designated beneficiaries. Eligible designated beneficiaries include surviving spouses, minor children, disabled or chronically ill individuals (as defined by the IRS), and anyone no more than ten years younger than the deceased. All other individuals excluded from the eligible designated beneficiary categories are deemed non-eligible designated beneficiaries.

*Until age 21 or up to age 26 if still in school

For eligible designated beneficiaries, the old stretch rules remained largely intact. Non-spouse eligible designated beneficiaries may take stretch RMDs over the longer of their lifetime or the owner’s remaining life expectancy starting no later than December 31 after the year of death (or they may be able to elect the 10-year rule treatment). Additionally, surviving spouses can decide between rolling the decedent’s assets into their own IRA or establishing an inherited IRA. For surviving spouses, rolling assets into their own IRA allows them to delay RMDs until their own required beginning date. This is a good option for spouses who do not need the funds right away to help pay for their current living expenses since withdrawals of assets before age 59 ½ from their own account would be subject to a 10% early withdrawal penalty in addition to ordinary income taxes.

Establishing an inherited IRA, however, allows the surviving spouse to withdraw assets prior to age 59 ½ without having to pay the additional 10% penalty and gives them the option to start RMDs the later of December 31 of the year following death or December 31 of the year the original owner would have attained RMD age. Please note, due to the SECURE Act 2.0, the age at which you must begin taking RMDs differs depending on when you were born. Lastly, if the original owner did not take their RMD before death and was required to, the beneficiary is obligated to take it in the year of death.

Heirs falling into this class are subject to the 10-Year Rule. With the 10-year rule, beneficiaries must distribute their inherited retirement account balance by the end of the tenth year following the year of death of the original owner. In 2022, the IRS also issued proposed regulations to clarify its position on the 10-year rule.

According to these regulations, if the original owner was required to take RMDs, non-eligible designated beneficiaries are expected to take annual RMDs in the first nine years and withdraw the remaining account balance in year ten. However, for account owners who have not yet reached RMD age, their beneficiaries will not be required to take annual RMDs. The inherited retirement account balance just needs to be distributed within a 10-year window following the original owner’s death.

Example 1: John Smith passed away in 2022 at age 75, leaving a 401(k) account with a balance of $250K to his adult daughter, Pam. Since John was required to take RMDs annually, Pam must take stretch RMDs for the first nine years and deplete the account by 2032 (since she is a non-eligible designated beneficiary).

Example 2: Lisa Jones passed away in 2022 at age 68 with an IRA worth $1M that she left to her son, Bob. Since Lisa was not required to take an RMD at the time of passing, Bob is not required to take RMDs from the inherited IRA. He must, however, withdraw the entire account balance in ten years.

Example 3: Gary Stevens passes away before RMD age and leaves his $50K IRA to his 12 year-old daughter, Sally. As a minor child of the deceased, Sally is an eligible designated beneficiary and must take RMDs under the old stretch rules starting the year following Gary’s death. At age 21, however, Sally is no longer considered a minor and loses her eligible designated beneficiary status (assuming she is no longer in school). As such, she is no longer required to take an RMD under the stretch rules but is now subject to the 10-Year Rule and must withdraw the remaining IRA balance by the time she reaches age 31.

Given the confusion surrounding the new regulations, as part of Notice 2022-53, the IRS announced they would waive the standard 50% penalty on missed RMDs in 2021 or 2022 for original account owners who passed away in 2020 or 2021. Starting in 2023, however, the IRS expects non-eligible designated beneficiaries who inherited a retirement account from an owner that was subject to RMDs to take their annual RMDs by December 31 each year or face a 25% penalty (or 10% if corrected in a timely manner) in addition to the RMD amount.

While traditional IRA withdrawals are fully taxed, Roth IRA assets can be withdrawn tax-free if certain conditions are met—potentially providing considerable tax savings for beneficiaries. Much like the rules for traditional IRAs, surviving spouses have the option to treat inherited Roth assets as their own (avoiding RMDs but subjecting the assets to a 10% early withdrawal penalty prior to age 59 ½) or leave the assets in an inherited Roth IRA account and take lifetime distributions starting at the later of the year after death, or the year the original owner would have reached their RMD age. For eligible designated beneficiaries, Roth IRA distributions are stretched over their lifetime, while non-eligible designated beneficiaries are not subject to RMDs but must distribute the full account balance by December 31 of the tenth year following the year of death.

Planning Ideas:

• Surviving spouses should determine if they need access to their deceased spouse’s retirement account to help pay for current living expenses. If the assets are needed before the surviving spouse turns 59 ½, using an inherited IRA will allow them to avoid the 10% early withdrawal penalty. Please note that inherited IRAs can be rolled over into the surviving spouse’s IRA at any time if the assets are no longer required to fund current living expenses.
• If the surviving spouse has the financial stability to avoid dipping into the inherited retirement account until retirement, they should consider rolling it to their own account to delay RMDs until their required beginning date.
• Beneficiaries should consider transferring inherited retirement assets to their own IRA and then converting them to a Roth IRA in one year (if the account balance is relatively small) or over several years. This conversion strategy requires taxes to be paid upfront but can remove the need to take RMDs in the future.
• Beneficiaries in lower tax brackets should consider taking more than the required minimum distributions to fill up their lower income tax brackets if paying the taxes now will minimize the overall amount of taxes paid.
• Beneficiaries who are working may want to consider increasing pre-tax contributions to their retirement plans to help offset the recognition of RMD income.
• Review beneficiary designations to ensure accounts will be transferred to the intended beneficiaries in the most tax-efficient manner.

The SECURE Act of 2019 significantly changed how inherited retirement assets are treated for beneficiaries. We recommend working with your Aldrich Wealth advisor, tax professional, and estate planning attorney if you have recently inherited retirement account assets to determine the best way to distribute them without incurring undue taxes or penalties. Lastly, it is important to work with your trusted team of advisors to review your estate plan regularly and ensure your assets are set up correctly to pass your hard-earned wealth to your heirs the way you intend. For additional planning resources, download our personal financial planner.